Better ask these 5 questions before picking a robo-adviser

Digital adviser services — commonly known as robo-advisers — can help you pick investments or even manage your portfolio for much less than a human adviser might charge.

What’s in your robot?

Regulators, though, are concerned that some investors don’t realize what they’re getting, and what they’re not, when they sign up with an online investment management site.

The Securities and Exchange Commission and the Financial Industry Regulatory Authority issued a joint alert in May saying people need to understand the limitations and costs of automated investment tools.

The automated takeover

The popularity of robo-advisers is exploding. The amount managed by online investment advice services is expected to triple this year to $60 billion. Startups such as Betterment, Wealthfront and Personal Capital have been joined by heavyweights such as Charles Schwab and Vanguard. In most cases, the digital advisers ask investors a few questions to create a portfolio using low-cost exchange-traded funds and then regularly rebalance the investments to the target asset allocation.

Fee advantage

The advisory fee for online investment managers is typically between 0.25% and 0.35%, compared with the roughly 1% many human advisers charge for assets under management. The cost of the underlying investments might be as low as .05% each year, compared with the 1% or so charged by a typical mutual fund.

Here’s what you need to know before signing on:

What are the terms and conditions? Regulators want people to understand the costs involved in any investment. Robo-advisers typically are pretty clear about theirs, because that’s one of their advantages, but investors need to understand the “all in” cost — the advisory fee, plus the cost of underlying investments — so they can compare that figure with other options.

And as with human advisers, investors also should find out if a digital adviser receives any form of compensation for offering, recommending or selling certain investments. Investors need to learn about the exit strategy: how they can terminate the relationship and how long it may take to cash out the investments if they stop using the tool.

What’s the investment approach? Most digital investment managers aim for superior returns by keeping costs low. Some people misinterpret that to mean the services can or will try to beat the market. In reality, most digital advisers use a passive investment approach, 1 that seeks to match market benchmarks rather than exceed them. Any site that offers investment analysis must describe the criteria and methodology it uses, so investors should review that information to understand the tool’s assumptions and limitations.

Since the tools often are programmed to consider only certain options, such as exchange-traded funds, investors should understand what those options are and why they were chosen. Are those the lowest-cost options available, or have the choices been limited to investments offered by an affiliated firm?

Is it asking the right questions? A good human adviser typically will ask clients questions about risk tolerance, how long they can leave the investment alone (their time horizon) and other details about their financial situation. No questionnaire is perfect, but investors should be wary of “questions that are over-generalized, ambiguous, misleading, or designed to fit you into the tool’s predetermined options,” regulators warn.

Do I need more help than a robo-adviser can give? An automated investment tool may not be able to consider or assess all the factors that influence a user’s investments. Many robo-advisers, for example, will manage only the money invested with them and won’t offer advice about other holdings, such as a 401(k) or an IRA at another brokerage.

Most don’t offer comprehensive financial planning that includes other money topics, such as budgeting, insurance, estate planning or taxes. While some robo-advisers combine digital advice with a human adviser, most do not, which means “you may lose the value that human judgment and oversight, or more personalized service, may add to the process,” the regulators note.

How is my personal information being used? Investors should read a site’s privacy policy, because personal information may be collected for marketing or other purposes not related to using the tool. This is a particular hazard for any so-called “free” site, investment-related or otherwise, since those that don’t charge users directly typically make their money from selling users’ data or from advertising shaped by that data.

Also, investors should take the usual steps to safeguard information by making sure to use secure sites (URLs that begin with “https” rather than “http”), employ strong passwords and not access the site through shared computers or unsecured hot spots.

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